Andrew Coyne: A little inflation has a way of becoming a lottle

Shake and shake the ketchup bottleNone’ll come, and then a lot’ll
— Richard Armour

The latest figures show inflation remains well under control: in both Canada and the United States, consumer prices have risen by less than 2% over the last year. If so, it’s not for lack of trying.

Led by the U.S. Federal Reserve, central banks across the developed world have been pumping vast amounts of money into their economies since the financial crisis, at a rate that in most normal times would be expected to produce much higher inflation. Yet not only has there been no inflationary surge, there’s no sign of it anywhere on the horizon.

Though interest rates have begun to rise — the yield on U.S. 10-year Treasury notes is now nearly 3% — this has much more to do with a strengthening economy, and the prospect of a “tapering” of the Fed’s monumental $85-billion a month program of bond purchases, than any expected increase in inflation. The spread between 10-year Treasuries and their inflation-indexed equivalent offers a good measure of inflation expectations: it has slightly narrowed over the past year, from 2.31 to 2.15 percentage points.

Still, just because inflation hasn’t broken out yet doesn’t mean it never will: shake the ketchup bottle long enough and something’s bound to come out. “You simply cannot keep real short-term interest rates negative for this long,” the economist David Rosenberg warns, “without generating financial imbalances and inflationary excesses down the road.” The rapid runup in commodity and asset prices this year may be a harbinger of increases in consumer prices further down the road.

Indeed, Rosenberg suspects that’s the Fed’s intent. “The reality,” he argues, “is that we now have a monetary policy that is dedicated towards getting inflation higher over the near and intermediate term.” Financial markets may not have picked up on this yet, just as it took years for markets to grasp that Paul Volcker really meant to get inflation down in the 1980s. But “it would be an exercise in futility to bet against that desire,” Rosenberg says.

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Whether inflation is or is not about to make a comeback, the more alarming trend is in the number of commentators, some prominent economists among them, openly advocating it. Nobody wants a lot of inflation, of course: nobody ever does. Just “a little,” say 4% to 6%.

The rationale: the recovery is being held back by “deleveraging,” as public and private sectors both seek to pare back the heavy debts they took on in the last decade. What simpler way of relieving them of that burden than by devaluing the currency in which it is denominated? Even at 4% per annum, inflation halves the value of the dollar inside of 18 years.

What a clever trick — only nobody tell the bond markets, okay? Because if indeed people get wind that governments are conspiring to welch on their debts and steal savings in this fashion, they may start to demand a higher interest rate to compensate. In the same way, please keep it a secret from labour negotiators, who may not sit idly by and accept a hefty annual cut in their living standards, but may insist on offsetting wage increases.

We are back to the 1970s, the last time people thought “a little” inflation would do us some good. At the time, there was believed to be a trade-off between inflation and unemployment. And indeed, the data seemed to support it: there was a statistical relationship between the two, memorably summarized in the Phillips Curve.

What a clever trick — only nobody tell the bond markets, okay? Because if indeed people get wind that governments are conspiring to welch on their debts and steal savings in this fashion, they may start to demand a higher interest rate to compensate

But it turned out the minute you tried to move along the curve, ginning up higher inflation in hopes of reducing unemployment, the relationship broke down. All you got was higher inflation. Why? Because it wasn’t so easy to “fool the workers” as all that — maybe you could at first, but not for long, and then not at all. The economist Bob Lucas won a Nobel Prize for pointing out, in effect, that people don’t just blindly carry on as before in the face of policy makers’ efforts to engineer higher inflation, expecting that because inflation has been low in the past, it will be in future. They take the hint. They form expectations about future inflation, and act accordingly.

And yet we are assured that, this time, policy makers will be able to spring a “surprise” on the markets. Good luck with that. And at what cost, if they do? Central banks have spent the last several decades building up precious credibility with economic actors: when they say they will do something, people believe them, making it easier for each side to plan around the other’s anticipated behaviour. All this would be squandered in a moment if this mad course were pursued.

Surprise, of course, is another word for deception. Inflation is, at bottom, a lie; an economy based on inflation is an economy based on lies. Every wage, every price, every promise to pay comes with a pair of crossed fingers: you’ll get this much, I swear (minus whatever inflation takes out of it). And since nobody knows quite how much to expect in the way inflation — central banks having proven themselves untrustworthy — everybody grows to mistrust each other, and to waste precious resources trying to guess where inflation is going. There’s a remarkable correlation between days lost to strikes and inflation: when inflation is high, management and labour both give themselves an extra margin of error, and in the gap lies room for conflict.

No thanks. We’ve no need to go back there. It may sound like an easy way out. But a little inflation has a way of becoming a lottle.